Election has big banks in crosshairs

Sandy Weill’s comments this week are just the latest dustup in the debate about the existence of financial institutions that are labeled by regulators and market participants as being too big to fail. Despite the criticisms leveled at these firms, the largest banks have only gotten bigger over the last few years – and U.S. regulators still appear underprepared to resolve a future failure of a systemically important financial institution without setting off broader market panic.

Against this backdrop, new bank reform proposals are likely to get a lot more attention on Capitol Hill heading into the November election. Catalysts for this debate are sure to include the stories around JPMorgan’s London Whale trader and the brewing Libor scandal.

In a recent paper, academics Frederic Schweikhard and Zoe Tsesmelidakis examined the borrowing advantage that large financial institutions had from 2007 to 2010 as result of the market’s perception that their liabilities were backed by the federal government. Taxpayers subsidized TBTF banks to the tune of $130 billion, according to their findings. Citigroup was the single biggest beneficiary of government support, totaling $50 billion, but even well capitalized JPMorgan is estimated to have gained $10 billion in value from taxpayer guarantees.

Privately, the big banks think this is old news. They are quick to note that Congress addressed the issue of taxpayer bailouts back in 2010, when it passed the 2,000-page Dodd-Frank financial reform bill. Among its many directives, the law created a new systemic risk council of regulators and tasked it with designing and implementing a new “resolution regime” for big and complex financial institutions. The goal was to empower a new council to regulate and oversee the failure of future financial institutions and to guard against taxpayer guarantees or systemic consequences for the overall economy. While it’s certainly debatable whether Dodd-Frank achieved some progress in this area, credit rating agencies are still signaling to the market that the government would likely step in and protect bank creditors. As long as this is true, big banks continue to have a borrowing advantage. Even granting additional discretion to regulators solves nothing if economic vulnerabilities still make a bailout the less harmful choice when the next crisis arrives.

During the debates this fall, Mitt Romney will surely confront President Obama on the limitations of the financial reforms that his administration advanced, including the Dodd-Frank Act. The TBTF problem stands above all others in this area and presents an opportunity for a defining contrast before the election. A new choir of analysts – including those on the right that are steeped in both policy and political strategy – are also starting to argue that what looks like good policy on the big banks might also be good politics (see here and here and here).

In the near term, Weill’s comments have helped push the policy spotlight back on whether a version of Glass-Steagall should be imposed – effectively drawing new lines between essential banking functions (i.e., deposit taking, settling payments and offering loans) and more speculative financial functions (i.e., brokerage and derivatives trading). Proponents of this idea argue that the latter should still be allowed – and under less regulation or supervision – but only without the promise of taxpayer support should one of these institutions fail. Deciding where to draw these lines can be extremely challenging, as proved by the rulemaking for permissible activities under the Volcker Rule, which is barely comprehensible even to the most seasoned experts.

While the chorus in favor of breaking apart TBTF banks into separate commercial and investment entities will surely continue, there are two other categories of reforms that are likely to get even more traction as this debate unfolds. The first would seek to impose more meaningful caps on the size and leverage of TBTF banks, effectively shrinking them over time. The second would attack the prospect of future bailouts head-on by making it clear upfront that the equity holders and creditors of TBTF institutions would face haircuts in the event of a failure.

Thomas Hoenig, a former Federal Reserve governor and current director at the FDIC, is the author of one of the more far-reaching proposals to restructure bank activities. The general thrust of this plan (as he calls it, a Glass-Steagall “for today”) would be for regulators to designate what activities are allowable – for example, traditional banking services, such as taking deposits and underwriting securities – while prohibiting more complicated tasks, such as proprietary trading or derivative transactions that expose banks to financial risks and increase the complexity of bank regulation.

The UK’s Independent Commission on Banking, commonly known as the “Vickers Report”, has offered a similar plan to ring-fence retail deposits and allow for limited risk management or hedging strategies. Outside the fence would be securities and derivatives trading, underwriting, and securitization. The fence would effectively separate bank subsidiaries so they would be operationally independent.

Both Hoenig’s plan and the ring-fencing concept essentially seek to bring back a Glass-Steagall-like barrier between commercial banking – everyday banking involving deposits and lending – and investment banking, which handles more complicated banking functions like security underwriting and company mergers. However, as University of Chicago economists John Cochrane and Luigi Zingales have argued, the real distinction is between financial intermediary functions – collecting deposits, making loans, serving as a broker between buyers and sellers of securities – and proprietary trading. These intermediary functions are socially valuable in that a lot of economic activity depends on their very existence. The same is not true of proprietary trading. Yet, losses on proprietary trading can erode the capital necessary to support intermediation.

On Capitol Hill,Senator Sherrod Brown just reintroduced the SAFE Act, which takes a different route by effectively shrinking the largest banks through a series of caps on the total share of bank deposits that one institution can control, caps on non-deposit liabilities, and a tougher limit on allowable leverage. What most people have forgotten is that a version of this bill was offered as an amendment to the Dodd-Frank Act back in 2010. While it failed to pass then, garnering only 33 votes in favor, parsing the yeas and nays reveals some important clues as to where senators may be heading in 2012. It’s particularly interesting that some key Republicans voted for his amendment, including Senators Richard Shelby and Tom Coburn. A few others sought to keep their powder dry on this tough vote, choosing to abstain (Senators David Vitter and Jim DeMint).

Over the last few years, other Republicans in the both the House (see Representative Spencer Bachus’s proposal) and the Senate (see Senator Jeff Sessions’s proposal) have introduced bills to update the bankruptcy code so there is an orderly way to resolve large and complex firms that are failing. (Creating a bail-in regime is also under consideration.) The measures all seek to improve the code as a means to promote market discipline and thus protect taxpayers long term. The principal advantage, compared with Dodd-Frank (and specifically Title 2), would be to substitute regulator discretion during the next crisis with clear rules that could eliminate any borrowing advantage in the near term, or imputed subsidy for banks and their creditors.

Bank bailouts are not favors randomly dispensed to clients – they are generally motivated by a desire to prevent the chaos that would arise from cascading losses. By reducing expectations of bailouts and increasing the cushions to absorb losses, clear rules and increased capital change the facts on the ground and make bailouts less likely. As long as market participants (and creditors specifically) interpret regulator discretion as increasing the chances that some government power will be used to bail them out when the next panic ensues, big banks will still be advantaged at the expense of taxpayers. The logic behind an alternative resolution regime is to squarely address the economic costs that bailouts seek to suppress.

A group of academics from across the country has come together to propose just such a thing: an entirely new chapter in the bankruptcy code. The authors note that the existing bankruptcy process does not work particularly well for large and complex financial firms, as we saw with Lehman Brothers. At the same time, the new bank resolution authority in Dodd-Frank is an incomplete fix. The current system preserves regulatory discretion over how to handle the failures of financial institutions and leaves open the possibility that some creditors may be bailed out in the future. It is better, this group argues, to fix the current bankruptcy regime so that clear rules govern the resolution of major financial institutions.

The overarching goal should be to change the expectations of market participants and regulators on the risk of future bailouts. Market participants should have incentives to engage in more extensive credit analysis and upfront monitoring of bank liabilities and leverage. This will make future bailouts less likely, because through greater market discipline there will be fewer panics. And if regulators perceive that banks can be allowed to fail in an orderly manner, they will also be less inclined to prop up or confirm their TBTF status through interventions and bailouts.

Driven by the political debate, policymakers will increasingly have reason to revisit several aspects of Dodd-Frank this fall and into 2013. The leading candidates to take over the chairmanship of the powerful House Financial Services Committee are certainly convinced that the system is still plagued by the TBTF syndrome. This is true both for Republicans like Representatives Jeb Hensarling and Ed Royce, as well as the next-in-line Democratic member, Representative Maxine Waters. Senators are likewise focused on the threat of future taxpayer bailouts, including the top Republican on the Banking Committee, Senator Shelby, and his Democratic colleague Senator Brown.

Thankfully, there is still time to fix financial regulation and end the bailouts that go along with too-big-to-fail banks.

Arpit Gupta, a Ph.D. student in finance at Columbia University’s Graduate School of Business, contributed to this column.

PHOTO: Sanford I. Weill, chief of the Travelers Group (L), and John S. Reed, chief of Citicorp, shake hands at a press conference in April 1998 in New York, where it was announced that the two companies would merge in a deal worth more than $70 billion.